The new investor guidelines by the capital market regulator, Securities and Exchange Board of India (Sebi), are a welcome step in the direction of creating more professional and transparent environment in the area of investment advice in the country. For the first time, investment advisory is being recognized as a valuable service. Until now, it was perceived that advice should be rendered free for earning commission/brokerage for distributing a financial product—free advice for paid distribution. These regulations segregate advisory fee and distribution commissions.

The macro picture

Need for an umbrella regulator: It is important to keep in mind that these regulations would regulate only those entities that fall under Sebi’s purview. Hence, entities like insurance agents, pension advisors, chartered accountants, company secretaries, legal professionals, and so on won’t fall under the purview.

Such handicap will continue to remain with all regulations due to lack of an umbrella regulator who has under it the Reserve Bank of India (RBI), Sebi and the Insurance Regulatory and Development Authority (Irda). Exclusion of stock brokers, merchant bankers and portfolio managers is a surprise. Those mutual fund (MFs) distributors who are members of self-regulatory organizations (SROs) are also excluded. Hopefully, the SROs that regulate MF distributors and SROs that regulate stock brokers will come out with guidelines ensuring its members act in a manner that keeps clients’ interest first. As far as banks and non-banking finance companies (NBFCs) are concerned, it is important for them to first obtain permission from RBI before applying to Sebi for an investment advisory license. We hope RBI allows department or divisions of banks and NBFCs that render investment advisory services to get regulated by Sebi, keeping in mind the larger interest of the customers.

What does fractured regulation lead to? Any regulation that is unable to regulate all the relevant entities creates inefficiencies and remains fractured regulation. This regulation will also fall in the same category unless it is able to regulate all the entities that give investment advice. Inefficiency in the regulation will create arbitrage opportunities for financial product distributors that will get exploited at the cost of investors even though the customer is the majority stakeholder in the entire system. A classic example is the increase in sale of unit-linked insurance plans (Ulips) when MF entry loads were banned. Sebi could only regulate MFs and could not establish its authority on expensive Ulips even though they were market linked.

Challenge for planners: Comprehensive financial planning focuses on income, expenses, assets and liabilities of a client before giving advice. There are times when the planner focuses only on estate planning or debt counselling or cash-flow management for a fee. Under such circumstances, the planner is not giving any kind of investment advice. Yet as per regulation, he will have to get registered and adhere to various compliance rules and other requirements. This will result into financial planners passing on the extra costs to the client. Ideally, financial planners should be regulated only to the extent to which he gives investment advice.

The micro picture

Risk profiling: Firstly, it is important to note that there isn’t any scientifically proven risk profiling theory that exists anywhere. Under the qualification and certification requirement, Sebi has mandated a few certifications. None of these certifications in their entire curriculum teach any kind of theory on how to assess the risk of a client.

While this may come as a shock to most readers, the term risk profiling is regularly used while discussing investments, it is a reality. Several entities use risk profiling questionnaires. However, if we were to question them on its scientific validity and the theory on which they are developed, there aren’t any satisfactory responses. An individual who has gained 10% on one instance and lost 10% on another instance would respond differently to the same questionnaire under different circumstances. Similarly, responses of a person who gets a 25% salary increment in one year but loses his job in another year would react differently to the same questionnaire because of changed circumstances.

Though it is true that investment advisors should factor in changes in internal and external environments before giving advice to clients, this should be done based on his qualifications, skills and experience and not on the basis of responses to a questionnaire. By laying emphasis on a questionnaire, the onus indirectly shifts to the responses given by the individual, which may be under the emotional influence of certain internal and external developments in his life. There have been several instances where an individual would have attempted such questionnaires of entities such as banks and financial distributors within a short span and the outcome of each on the risk-taking capabilities of an individual would be drastically different.

Suitability: Under this section, Sebi expects investment advisors to make recommendations where the client has necessary experience and knowledge to understand the risks involved in the transactions. This will lead to a situation whereby the advisor will have to give advice not based on his qualification and experience but based on the knowledge and experience of the client.

The issues discussed here are areas that need attention to ensure that the overall spirit of regulation prevails. Sebi has taken a historical step but the government has to realize that if regulations need to be made in a manner that benefits the end user, an umbrella regulator would be required. Investors need to realize that if they want advice to create wealth, they need to remunerate someone who helps them achieve that.